4504c8 - Bond Yields and Prices Chapter 8 Interest Rates o Interest rates measure the price paid by a borrower to a lender for the use of resources

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Unformatted text preview: Bond Yields and Prices Chapter 8 Interest Rates o Interest rates measure the price paid by a borrower to a lender for the use of resources over time o Interest rates are the price for loanable funds • Price varies due to supply and demand for these funds Rate variation is measured in basis points Rates and basis points 100 basis points are equal to one percentage point Determinants of Interest Rates o Required rate of return: o risk-free rate + a risk premium o Short-term riskless rate Provides foundation for other rates Approximated by rate on Treasury bills---risk-free rate • Fisher hypothesis o RF≈RR+EI Nominal short-term rate rises with anticipated inflation Expected real rate estimates obtained by subtracting the expected inflation rate from the observed nominal rate Realized real short term rate may be less than expected if experience unanticipated inflation Real interest rate is an ex ante concept Other rates differ because of • Maturity differentials • Security risk premiums o Maturity differentials Term structure of interest rates • Accounts for the relationship between time and yield for bonds that are the same in every other respect—Liquidity Premium Theory o Risk premium Yield spread or yield differential Associated with issuer’s particular situation or particular market Measuring Bond Yields o Current Yield annual coupon interest in dollars = C • Current yield = Current Price P • Does not account for capital gain (loss) o Yield to maturity Most commonly used Promised compound rate of return received from a bond purchased at the current market price and held to maturity • Assumes: o Interest payments reinvested • Reinvested at computed YTM Equates the present value of the expected future cash flows to the initial investment • Similar to internal rate of return Yield to Maturity o Solve for YTM: Approximation formula: Par Value - Current Price coupon interest in dollars + n___________ Current Price + Par Value 2 • where n is the number of years to maturity Exact formula: n 2 )) 2 / r ( 1 ( ParValue C .... 2 )) 2 / r ( 1 ( C )) 2 / r ( 1 ( C ice Pr n 2 2 1 + + + + + + + = • Solve for r by trial and error. For a zero coupon bond YTM= (Par Value/Price) 1/n-1 o Investors earn the YTM if the bond is held to maturity, all coupons are reinvested at YTM, and rates do not change Other Yields • Treasury bill yields: Discount yield (d): • ) 100 ice Pr 100 ( * n 360 d- = o where n is number of days to maturity; price is expressed in dollars per $100 of par value or face amount. Equivalent bond or coupon yield (i): ) ice Pr ice Pr 100 ( * n 360 I- = • Yield compounding: For Finite compounding • Realized yield (Effective Yield) = (l + r/m) m- 1 • where o r = stated interest rate per year, o m = number of times interest is compounded per year....
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This note was uploaded on 07/09/2011 for the course FIN 4504 taught by Professor Banko during the Summer '08 term at University of Florida.

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4504c8 - Bond Yields and Prices Chapter 8 Interest Rates o Interest rates measure the price paid by a borrower to a lender for the use of resources

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